An arm’s length transaction, also known as the arm’s length principle (ALP), indicates a transaction between two independent parties in which both parties are acting in their own self-interest. Both buyer and seller are independent, possess equal bargaining power, are not under pressure or duress from the opposing party, and are acting in their own self-interest to attain the most beneficial deal.
Due to both parties acting independently and in their self-interest, an arm’s length transaction is a transaction that closely matches the fair market value of the consideration.
For example, consider a buyer and seller who are acting independently and do not know each other. In such a scenario, each party wants a price that maximizes their welfare. The buyer would issue a bid as low as possible while the seller would issue an offer as high as possible.
Each party would then use information available to them to bargain and eventually reach an agreement. Therefore, the price that the buyer and seller are willing to transact on would closely match the fair market value of the consideration.
Colin is looking to sell his house as he is moving to another country. His older brother, John, is coincidentally looking for a house to purchase. Before accepting offers, Colin gets an appraisal for the house and determines that the fair market value of the house is $1,000,000. Colin receives an offer from a stranger for $950,000 and from John, who is short on cash, for only $600,000.
If Colin sells the house to the stranger, it would be an arm’s length transaction because both parties are independent and acting in their own self-interest.
If Colin sells the house to John, it would not be an arm’s length transaction because both parties are not independent – Colin is influenced by John because the latter is a family member. In addition, John’s offering price of $600,000 is significantly lower than the determined fair market value of the house based on the appraisal.
Although John’s welfare is maximized due to him being able to purchase the house at his offer price, Colin is not acting in his own self-interest to attain the best deal.
Public companies that do not conduct transactions at an “arm’s length” are frowned upon by investors, and this often results in a significant depression in their stock price. A notable example that made headlines in 2018 was Aphria Inc. from a short-seller report issued by Quintessential Capital Management.
Gabriel Grego, the founder of Quintessential Capital Management, issued a report in conjunction with Hindenburg Research, making allegations that Aphria, among other issues, overpaid to acquire foreign assets that were essentially worthless. Grego called Aphria a “black hole for shareholders’ money.”
The impact of the report, indicating that Aphria’s acquisition of assets in Latin America was not at arm’s length, caused the stock of Aphria to plunge. The company’s shares declined 40% over a two-day period.
Following the release of the report, Aphria denied the accusations and issued a rebuttal stating that the transactions were “negotiated at arm’s length between two publicly traded companies, each of which retained professional financial advisors.”
Since then, Aphria’s shares have recovered from the short-seller attack, and a special committee of independent directors that reviewed the allegations have concluded that the transactions were indeed executed at an arm’s length.
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